The carbon bubble will burst - we must be prepared this time

The Carbon Tracker Initiative should be talk of the town in Davos, the fact it won't be suggests we are heading for another crash

23 Jan 2012, 14:50

This is really important. No matter where you stand in the green debate, the threat posed by the systemic over valuation of carbon intensive firms and assets is a critical issue that should concern you - really, really concern you.

Regardless of whether you are the most committed eco-warrior, the most pragmatic business leader, or the most unyielding climate sceptic, the failure to acknowledge the inherent risks of slapping triple A ratings on carbon intensive firms and assets that are incompatible with governments' climate policies and scientists' climate warnings risks fuelling a "carbon bubble" that could make the on-going fall out from the most recent global investment bubble look like a boom time.

That is the warning currently being sounded by the recently launched Carbon Tracker Initiative, which last week released its second report on the scale of the so-called "carbon bubble" and wrote to Bank of England Governor Mervyn King urging him to take action.

The two reports from the group - which is backed by some high profile green thinkers and investors, including the WWF, Solarcentury chairman Jeremy Leggett, former chief scientist Sir David King, and Conservative MP Zac Goldsmith - should be required reading for political leaders, business leaders, and economists everywhere. If there was any sense of proportion, it would be at the top of the agenda at this week's annual billionaire schmooze-fest at the World Economic Forum in Davos.

The premise set out in the reports is simple, so simple it's terrifying.

Many of the world's top indices are dominated by energy firms whose valuations are largely determined by the fossil fuel assets they hold directly or their ability to access the assets held by their suppliers. The stocks and shares of these companies are typically regarded as triple A rated, gold plated, low risk assets that are highly attractive to investors such as pension funds seeking stable long term returns. The only problem is that like the sub prime mortgages that sparked the crash of 2008, they are, from an environmental perspective, junk.

According to a report last year from the Carbon Tracker Initiative, of the declared assets held by the top 100 listed coal companies and the top 100 listed oil and gas companies globally only 20 per cent can be burnt if the world is to hold any hope of limiting average temperature rises to 2°C (assuming of course we are not on the brink of the mass global roll out of successful carbon capture and storage technology). The valuations of 200 of the world's largest companies - companies who underpin our pensions and dominate global markets - are based to a huge extent on fossil fuel reserves that according to the stated climate change goals of the international community cannot be accessed.

As the letter to King puts it,"the depth and breadth of our collective financial exposure to high carbon, extractive and environmentally unsustainable investments could become a major problem as we transition to a low carbon economy. Five of the top 10 FTSE 100 companies are almost exclusively high carbon and alone account for 25 per cent of the index's entire market capitalisation."

Some optimistic analysts might argue valuations are based in part on these high carbon firms' ability to transform themselves into major players in the emerging low carbon economy, and in fairness some carbon intensive firms are taking steps to decarbonise. But this does not explain why many of those companies that have taken no real steps to diversify their operations remain highly rated, nor why something as risky as the complete transformation of a fossil fuel-based business model is not reflected in valuations or rating agency assessments.

Others might argue that there is nothing wrong with the market, that climate change isn't happening, and that fossil fuel based energy firms offer one of the safest investment categories available. But this argument is not just scientifically illiterate; it also runs counter to the policy direction being pursued by countless governments around the world. You might not believe manmade climate change is happening, but the world's leaders do, and they are committed to doing something about it. They might not be acting as fast as environmentalists would like, but they are acting through measures such as carbon trading and taxes in the EU, Australia, California and soon China, vehicle fuel efficiency standards in jurisdictions around the world, and subsidies and incentives designed to make clean technologies more competitive. The valuations of fossil fuel-based assets do not appear to adequately reflect the risk posed to them by emerging policies purposefully designed to curb demand for their products.

Just as with the pre-crash years, a huge investment bubble is being fuelled by the over valuation of assets where enormous systemic risks are being either mistakenly ignored or deliberately underplayed.

And again, as with the 2008 crash, efforts to keep this bubble going are leading to staggering levels of corruption and lobbying designed to undermine any effort to bring the market back under control. The failure to acknowledge the long term environmental and legislative risks faced by high carbon firms continues to fuel the carbon bubble, undermining green policy efforts by sending out signals that the market (or at least the short-sighted ratings agencies, analysts, and investors who control the market) does not believe political and business leaders when they say they will build a low carbon economy. All of which in turn provides high carbon companies and investors with a further financial incentive to ignore the risks they face.

Anyone doubting this analysis, witness the utter lack of controversy last week when BP issued an outlook suggesting global greenhouse gas emissions will rise 28 per cent by 2030. One of the world's largest firms tells investors its plans are largely based on a scenario that the vast majority of climate scientists believe will result in global catastrophe, and no one bats an eyelid.

The question is what can now be done to correct this staggering market failure. If the last few years have taught us nothing (and I am starting to believe that they haven't), it is that we need to carefully deflate the bubble rather than sit back and watch it burst, taking the livelihoods, pensions, and savings of millions of people with it.

In order to achieve this managed decline we first need to properly understand the scale and reach of the problem. Think tanks and policymakers with even the vaguest interest in market failures or environmental economics need to pick up on the work pioneered by the Carbon Tracker Initiative. Meanwhile, Sir Mervyn King needs to respond immediately to last week's letter, confirming that hw will use his role as chair of the Financial Policy Committee (FPC) to as requested "investigate how the UK's exposure to high carbon investments might pose a systemic risk to our financial system".

Next, steps need to be taken to give investors and pension funds proper visibility over the carbon bubble. The government could start this process by finally giving the green light to long-awaited mandatory carbon reporting rules for listed firms, which many investors and big businesses are calling for. Similarly, governments the world over should build on emerging US efforts to ensure firms report annually on the climate-related risks they face. Give enough investors enough visibility over climate risks and the market might just start to do its job again.

Finally, politicians and regulators need to grow a backbone and use their bully's pulpit to stand up to the ratings agencies and carbon intensive lobbyists who refuse to believe low carbon policies will prove successful. There needs to be a consistent and vocal campaign to convince the market that high carbon assets are loaded with environmental and regulatory risks that investors need to be aware of.

For the last 20 years, politicians and regulators were asleep at the wheel, allowing a bubble to inflate which when it burst pushed the global economy to the brink of collapse. Less than four years on and there is ample evidence precisely the same thing is happening again, only this time it is both the global economy and the global ecosystem that could collapse. Investors, pension funds, politicians, and business leaders all need to wake up to these risks, and fast. As I said at the start, this is really important.

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Previously known as the BusinessGreen Blog, James' Blog features musings, observations and occasional rants from BusinessGreen editor James Murray

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